SocGen-US dollar might strengthen soon and cause the next financial crisis

When the dollar is in a bear market, liquidity flows into emerging markets, causing their currencies and asset prices to appreciate, which supports domestic demand.

As the U.S. economy recovers, a strengthening dollar might cause the next financial crisis, warns Singapore-based economist Andy Xie.

“The first dollar bull market in the 1980s triggered the Latin American debt crisis, the second the Asian Financial Crisis. Neither was a coincidence,” Xie writes for Caixin Online.

“When the dollar changes direction, so does liquidity. The virtuous cycle on the way up becomes a vicious one on the way down. The emerging economies already suffer inflation. The liquidity outflow leads to currency depreciation, which worsens inflation.

When the dollar’s value falls, dollar debt tends to rise in emerging markets, as the weak dollar lowers debt service and encourages overborrowing. But when the dollar reverses course and strengthens, the debt burden becomes unsustainable.

The BRIC countries (Brazil, Russia, India and China) are bubbles ready to pop, he warns.

“Whenever there is a hot concept like BRIC, there is a bubble. There has never been an exception,” Xie writes. “The BRIC countries exhibit all the symptoms of binging on cheap credit: high levels of indebtedness, inflation and strong currencies.”

The BRIC countries have seen inflows of foreign capital dissipate, and they are much like Southeast Asian countries just before the 1996 crisis. A wrong policy move could prompt a “full-blown financial crisis.” The right move for the BRICs is to raise interest rates to tighten money supply now.

But don’t count on that. They seem more interested in sustaining short-term growth, Xie says. “Some emerging market turbulence is quite likely within the next 24 months.”

Ouch! Let’s hope the guy is wrong… but why exactly will the dollar strengthen?

SocGen’s Sebastien Galy explained in a note to clients why we’re entering a “strange world” where the dollar is bound to strengthen.

Last week, US trade deficit shrunk by far more than expected, in large part thanks to declining oil imports. The decreasing need for oil from abroad is basically a result of two secular trends: Americans are driving less and the US is producing more oil.

Here is a snapshot form his recent analysis:

“… it is the steady accumulation that matters for the trade balance and the USD. This global imbalance has risen to the size of an elephant as the rest of the world grew more from exporting to the US… the elephant has been riding on four increasingly restive turtles and holding the weight of the world on its shoulders. This elephant is on a diet.

The US trade balance shows rising evidence that the US is moving towards energy independence, changing fundamentally the path of the US current account balance and the Fed’s ability to weaken the USD. Add to this the steady risk of tighter fiscal policy which would reduce the need for external funding plus the pressure on corporates to hand over their cash stored mainly in EM and we are in a strange world where the USD is doing better in a risk rally.

The US trade balance was notable by the lower demand for energy. As this vulnerability diminishes, it has economic and strategic implications. Strategic implications suggest a lighter US footprint globally and hence more political risks abroad as some have noted. Economic implications vary from the lower need to hedge oil imports which strengthens the USD to an improved balance sheet for the US. The Fed’s ability to weaken the usd is reduced as the back end of the UST curve will be in limited demand from foreigners, if they continue to expect an eventual normalization of Fed policy. A higher yield reduces the need to divest out of the USD, reducing an accelerator of usd weakness.”

Source: MoneynewsBusiness Insider